10 Apr 2015 Creating A Paycheck In Retirement
This week’s Brief comes to us from our good friend and like-minded colleague Russ Thornton, an Atlanta-based financial advisor. Russ is a thought leader in the area of financial planning, and puts out rock-solid content each week over at his website (and via an email which all of us subscribe to). His post this week on moving past rules of thumb and avoiding overly expensive products while still creating retirement income was spot on, so we decided to share it with you all! Take it away, Russ:
Regardless of your age or occupation, many of you plan to retire at some point in the future.
So let’s assume you’ve arrived at that point in your future.
Whether you’ve just retired from a tenured teaching position or are hanging it up after years on the road as a commission-earning sales person, your income – whether it was consistent or not – is going away.
Hopefully you’ve done a good job planning and saving for this day and the years that follow, but it’s still an uncomfortable feeling.
You’re walking away from a stream of income, and even though you had to work in exchange for that income, now that the income is going away, how will you make your finances and your life work?
I have some good news for you.
You can create a paycheck for yourself in retirement.
However, instead of your paycheck coming from ACME Corp. it will now come from your savings and investments.
Many people plan to retire and live on the dividends and interest from their portfolios. They consider their portfolio principal to reside behind a sheet of glass with the words “break glass only in case of emergency” written in bold red letters.
For some this approach might work.
But there is more than one way to skin the “retirement income” cat.
Let’s say you have a portfolio worth $2 million that you’ve accumulated over a 40-year career.
If you retire and put your entire $2 million into 10 year US government bonds, you could, based on today’s interest rates, generate approximately $37,600 per year in interest income. As I write this, the yield on the 10 year Treasury is at 1.88%.
Even if you’d be happy with this level of income, your principal is losing purchasing power every year as inflation slowly (but surely) erodes just how far those principal dollars will go in the future.
How about the 4% rule of thumb?
There is a widely accepted and research-supported rule of thumb that indicates you can take 4% from your portfolio each year to create a sustainable income stream that will withstand every economic and market environment we’ve ever experienced.
And the the “4% approach” will conceptually leave enough potential growth in your portfolio to keep up with inflation over time.
So there. You just went from a 1.88% yield (based on 10 year Treasuries) to 4% portfolio yield.
In dollar terms, that’s a “pay raise” from $37,600 per year to $80,000 per year (4% of $2 million).
But I hate rules of thumb, and you should too.
The 4% rule ignores how much investment risk you’d have to expose yourself (and your money) to in order to make the numbers work.
And this particular rule of thumb doesn’t account for the fact that you may want to spend more in your earlier retirement years and less in your later retirement years when you might be less mobile and less active.
At this point, your friendly broker or insurance agent has the solution you’ve been looking for. Sure, 4% sounds great, they say, but what happens when the market goes down? If your portfolio drops by 25%, your 4% (now on a portfolio worth $1.5 million) is only $60,000 per year. You’ve just taken a 25% pay cut based solely on the whims of the market.
What if, they ask you, there were a product that gives you market returns when the market is going up, but offers complete protection when the market goes down?
No, it’s not too good to be true, they say. Just put your money in an equity indexed annuity contract.
What they often fail to mention is that your money is locked up under sizable withdrawal penalties for 6-10 (or more) years, market performance doesn’t include dividends (which is a big part of market returns over time), and they’re going to charge you somewhere between 2-4% per year for the privilege of this not-so-perfect insurance product.
For more on the trouble with annuities and their guarantees, read this.
Here’s what I suggest . . . think of your retirement income and your portfolio like a pension. Some of you will remember that I’ve written about this concept before.
As you may know, pensions can be over- or under-funded. So why can’t your financial plan?
In plain English, why couldn’t you create and manage a flexible retirement income plan that reflects your personal situation, preferences and priorities along with changing personal, professional and economic circumstances?
In this scenario, you can literally have a dollar amount transferred into your checking account once or twice a month (much like a paycheck) and when the market does well, you could potentially:
- Give yourself a pay raise,
- Reduce your investment risk (sell some stocks while they’re high) and keep your “pay” the same,
- Add or increase other goals, or
- Some combination of the above.
Conversely, when the market goes through a bear market cycle, you can:
- Take a temporary pay cut,
- Increase your investment risk (buy more stocks when they’re low) and keep your “pay” the same,
- Reduce or delay other goals, or
- Some combination of the above.
Makes sense, doesn’t it?
And by the way, over time, this approach can likely create greater average income from your portfolio than even the 4% rule of thumb.
But as you may suspect, this only works if your personal plan is the centerpiece of your financial planning and decision-making process. Creating a plan once, and only looking at it every 2 or 3 years won’t cut it.
In fact, you don’t need or want a plan at all.
You want “planning.”
You want the verb, not the noun.
It’s an ongoing process where you don’t rely on forecasts or yesterday’s news. You simply update your plan on a consistent basis and incorporate new information as you get it. Then you stress-test your plan to see what might happen in the future based on what you know today.
This isn’t a forecast. This is an exploration of all the potential outcomes you may experience, and then you can establish the right combination of your goals (based on your priorities) that gives your plan sufficient comfort and confidence of working in all types of future environments as long as you continue to make small adjustments along the way.
This is an important concept and is counter to most financial advice that is dispensed today.
If this personalized, flexible approach sounds interesting to you, I’m pleased to let you know that it’s a fundamental premise that’s baked right into my financial advice process.
If you’d like to learn more or discuss how it might impact your situation, give me a call.